Energy Reaching Max Pain

Today the price of WTI crude oil rose 3.19%. Normally that would be a hugely bullish sign for oil, however, last week the price dropped 8%. With driving season well behind us and existing wells still pumping out oil, it will take two things to happen before oil prices rise and hold at a higher range. The first thing is on the way. The second, the Saudi's control when that happens. Before we get into what needs to happen for higher oil prices, let's take a look at what the market looks like.

Since going out to North Dakota for the second time in 2012 - the first time was 2005 when I got just a hint of what was to come - oil production has peaked and plummeted. On the right you can see a chart from an article on MarketWatch today. It shows the the plateau that oil production has fallen off in North Dakota. It is interesting that oil production was only growing at about 2% per year in 2013 and 2014 before falling to slightly negative growth in 2015. For 2016, production is likely to fall over 10% as depletion rates are about 40% on existing wells and only about 2/3 of the depletion will be replaced with new productive wells in 2016. North Dakota, due to the harsh winters, are not likely to see an increase in production growth again until spring 2017. This impacts any potential investments in Williston centric oil plays significantly.

A similar dynamic is occurring across the Eagle Ford and Permian in Texas, as well as, Alaska. In Texas, they production growth can resume by Q4 of 2016 if prices warrant, however, in Alaska, like North Dakota, we wouldn't expect production growth until at least spring 2017.

Over the next year, U.S. based oil production will likely drop by about 10% overall from 9,300,000 barrels per day to about 8,400,000 barrels per day by my estimates. The U.S. Energy Information Agency projects about 8,800,000 barrels per day of U.S. production, but they have been chronically high in their estimates. Either decline in oil production is significant as global oil production currently exceeds demand by about 2 million barrels per day.

In addition to declines in U.S. based oil production, we will see massive declines in global offshore production in 2016 and 2017 as depletion occurs and is only partially replaced as many projects have been put on hold. In the North Sea, the International Energy Agency expects production to fall by 150,000 barrels per day as new production is comparatively expensive and older wells are depleting quickly. Consider that virtually none of the oil field rights offered by Brazil this autumn received bids from the majors and that Royal Dutch Shell after spending $7 billion on an Alaska oil field pulled up anchor and canceled the project. There is going to be at least a 2 year decline in deep sea oil production and likely longer as the majors are not likely to risk money on any projects at the upper end of the price scale. Shell indicated they would likely not be back to Alaska until later in the next decade.

Even without cuts by OPEC, global oil supply and demand should be roughly in balance by next summer as demand inches upward and supply falls dramatically in the U.S., Canada and the deep sea. What is most likely to occur is that by the spring OPEC meeting Saudi Arabia is able to support a deal between OPEC members and Russia to create a price band on oil with Saudi Arabia and Russia as the swing producers. That price band per barrel of oil would likely be around $80 per barrel. The implicit threat to deep sea producers and U.S. frackers is that any significant production growth would be met with another round of predatory production by Saudi Arabia and Russia which has also increased production.

In the long-term it is not the core U.S. frackers that suffer. Rather, the losers are the marginal rock producers with high debt who are now going bankrupt and deep sea oil drillers that require price stability. I would not expect the oil majors to pursue much in the way of deep sea oil drilling again for several years at least. As the high cost producers, deep sea oil drilling, as I described a few months ago is going to be flat to declining for years.

Finally, there is an impact on less oil production on natural gas as a significant amount of natural gas is produced when oil is drilled. With oil production falling in the U.S. as a result of less oil drilling, the domestic market for natural gas is going to start to rebound as soon as this winter, but likely more significantly in 2016-17 after El Nino has blown itself out. The impact on lower credit lines and high debt producers shuttering or at least no longer increasing production will also have major impacts on natural gas production just as more coal fired power plants go off line, LNG exports begin, domestic demand increases and Cuba starts looking to convert its energy utilities from oil to gas. I will have a lot of say about natural gas in my updated report due to subscribers right Thanksgiving weekend.